CHAPTER1

INTRODUCTION
Chapter Summary
The purpose of this chapter and of the entire textbook is to teach you to think like an economist.
Economistsareuniqueinthewaythattheyviewtheworldandapproachproblems.Thekeyassumptionof
economics(especiallymicroeconomics)isthatindividualsallocatetheirscarceresourcessoastomake
themselvesaswelloffaspossible.Thisassumptioniscentraltoeconomics;thereisaneconomicwayof
thinkingthatisdifferentanddistinctfromthemethodsofothersocialsciences.
Microeconomicsisthestudyoftheallocationofscarceresourceshowindividualconsumersandfirms
(producers)makedecisionsandhowthesemanydecisionsinteract.Economicresourcesarethefactorsof
productionavailableforproducinggoods.Scarcityexistswhenpeoplewantmorethantheycangetwith
their limited resources. Scarcity implies that society must make tradeoffsthat we must give up
somethingtogetmoreofanotherthing.Forexample,ifIwanttospendanhoursleeping,Icannotgetit
withoutgivingupsomethingelse,suchasanhourofstudying.
Societyfacesthreekeytradeoffs: what goodsandservicestoproduce, how toproducethem,and who
gets the goodsand services. A market isan exchange mechanism (such as a physical structure or a
computer network) that allowsbuyers totrade withsellers.In amarket economy thethree allocation
outcomes(what,how,andwho)reflect theinteractions ofindependent decisionsmadebymillionsof
individualconsumersandfirms.Priceslinkandcoordinatethethreesetsofdecisions.Pricesinfluencethe
decisionsofindividualconsumersandfirms,andtheinteractionsofthesedecisionsbyconsumers,firms,
and thegovernment inturn determine prices. Most of thetextbookisconcerned withhowprices are
determined withina market and the conditions(number of buyers and sellers, amount of information
available)thatdeterminewhetherpriceisequaltothecostofproduction.
Amodelisadescriptionoftherelationshipbetweentwoormorevariables.Economicmodelsbeginwith
simplifyingassumptionsandthendeducetheimplicationsoftheseassumptions.Economictheory isthe
development and use of a model to test hypotheses, which are predictions about cause and effect.
Economiststesttheoriesbycheckingwhether thepredictionsofmodelsarecorrect. Agoodtheoryis
relativelysimpletouseandmakesclear,testablepredictionsthatarenotrefutedbyevidence.Ifamodelis
toosimple,itspredictionsmaybe incorrect. If amodel istoocomplex, all ofitspredictionswill be
ambiguousand,therefore,untestable.
Akeyassumptioninalmosteverymicroeconomicmodelisthatindividualsallocatetheirscarceresources
soastomakethemselvesaswelloffaspossible.Thisassumptionofmaximizingsubjecttoconstraints
impliesthatconsumerspickthebundlesofgoodsthatgivethemthegreatestpossibleenjoymentandthat
firmstrytomaximizetheirprofitsgivenlimitedresourcesandexistingtechnology.
Individuals, firms, and governments use microeconomic models and predictions tomake decisions.A
scientificpredictioniscalledapositivestatement:atestablehypothesisaboutcauseandeffect.Positive
doesnotmeanthatwearecertainaboutthetruthofthestatementitonlyindicatesthatwecantestthe
statementstruth.Anormativestatementisavaluejudgmentaconclusionaboutwhethersomethingis
goodorbad.Inmakingeconomicpolicies,economistsusepositiveeconomicstopredictwhatwillhappen
ifcertainpoliciesareadopted,andthenusetheirbeliefsandjudgmenttoselectwhichofthepoliciesyields
thebestoutcome.Economistsareusuallycarefultoseparatetheirpredictionsfromtheirjudgmentsofright

andwrong.Thisoftenrequirescarefuluseoflanguage,suchaswhentheeconomistpointsoutthatwhat
manypeoplecallneedsareactuallyonlywants.

Key Concepts and Formulas

Microeconomics:thestudyoftheallocationofscarceresources.
Scarcity:thesituationthatariseswhenpeoplewantmorethantheycangetwiththeirlimited
resources.
Tradeoffs:measurehowmuchofonethingmustbegivenuptogetmoreofanotherthing.
Market:anexchangemechanismthatallowsbuyerstotradewithsellers.
Prices:measurethetradeoffsavailableinthemarketplaceandcoordinatetheindependent
decisionsofconsumersandproducers.
Model:adescriptionoftherelationshipbetweentwoormoreeconomicvariables.
Theory:thedevelopmentanduseofamodeltotesthypotheses,whicharepredictionsaboutcause
andeffect.
Economistsassumethatindividualsexhibitmaximizingbehaviorthattheyallocatetheirscarce
resourcessoastomakethemselvesaswelloffaspossible.
Positivestatement:atestablehypothesisaboutcauseandeffect.
Normativestatement:avaluejudgment.

Application: Agreement Among Economists

Storiesabouteconomistsdisagreeingamongthemselvesarelegendary.Yeteconomistsinsistthatthereis
aneconomicwayofthinkingandspeakaboutkeyassumptionsthatalmostalleconomistshold.
Question:Doeconomistsagreewitheachotheronanyimportantissues?Ifso,whydotheyagreeonsome
issuesanddisagreeonothers?
Answer:Asshownbelow,recentsurveysshowthateconomistsactuallyagreeaboutalotofthings,but
thattherearemajordisagreementsonotherfundamentalissues.Theresultsshowthatthereisoftenmore
agreementonthesubjectwearenowstudyingmicroeconomics.Thismaybebecausemosteconomists
agreewiththecentralassumptionofmicroeconomics:thatalmostallindividualsallocatetheirscarce
resourcessoastomakethemselvesaswelloffaspossible.Thisessentialpostulateleadstoanumberof
clearpredictions.Aggregationtothemacroeconomiclevelinvolvesfeedbackeffectsandhardto
understandcomplications.Thisisprobablywhatexplainsthelackofconsensusonmanykey
macroeconomicissues.Ingeneral,economistsaremorelikelytodisagreewhen(1)theydisagreeaboutthe
appropriatemodeltouse,(2)theydisagreeabouthowtointerpretdata,and(3)theydisagreeabout
normativeissues(i.e.,whatshouldbedone).
Noteveryoneagreeswiththecentralassumptionsofmicroeconomics,however.Arecentsurveyasked
socialscientistswhetherornotindividualsarerationalutilitymaximizers.Amongeconomists,70
percentagreedandonly13percentdisagreed.However,amongpoliticalscientists,only33percentagreed,
while43percentdisagreed.
MicroeconomicPropositions

PercentAgreeing

1. Pollutiontaxesormarketablepollutionpermitsareamoreeconomicallyefficientapproach
topollutioncontrolthanemissionstandards.
2. Tariffsandimportquotasusuallyreducegeneraleconomicwelfare.
3. Aceilingonrentsreducesthequantityandqualityofhousingavailable.
4. Cashpaymentsincreasethewelfareofrecipientstoagreaterdegreethandotransfersinkind
ofequaldollarvalue.
5. TheSocialSecuritypayrolltaxisbornealmostentirelybyworkers,nottheiremployers.
6. Aminimumwageincreasesunemploymentamongyoungandunskilledworkers.

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7. EconomicevidencesuggeststhattherearetoomanyresourcesinAmericanagriculture.
MacroeconomicPropositions

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PercentAgreeing

1. AneconomyinshortrunequilibriumatarealGNPbelowpotentialGNPhasaself
correctingmechanismthatwilleventuallyreturnittopotentialrealGNP.
2. Intheshortrun,areductioninunemploymentcausestheinflationratetoincrease.
3. TheFederalReserveshouldincreasethemoneysupplyatafixedrate.
4. Themajorsourceofmacroeconomicdisturbancesissupplysideshocks.

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Sources:RichardAlston,J.R.Kearl,andMichaelVaughan,IsThereConsensusamongEconomistsinthe1990s?
American Economic Review: Papers and Proceedings, May 1992; Robert Whaples, Is There Consensus among
American Labor Economists? Journal of Labor Research, Fall 1996; Dan Fuller and Doris GeideStevenson,
ConsensusamongEconomists:Revisited, JournalofEconomicEducation,Fall2003;RobertWhaplesandJacC.
Heckelman,PublicChoiceEconomics:WhereIsThereConsensus?AmericanEconomist,Spring2005.ArePublic
ChoiceScholarsDifferent?PS:PoliticalScienceandPolitics,forthcoming.Note:PercentAgreeingsumsthosewho
generallyagreeandthosewhoagreewithprovisos.

Practice Problems
MultipleChoice
1. Askingwhetheranincreaseintheminimumwagewilldecreaseemploymentis
a.aquestionofpositiveeconomics.
b.aquestionofnormativeeconomics.
c.neitheranorb.
d.bothaandb.
2. Whichofthefollowingisapositivestatement?(Morethanonemaybecorrect.)
a.Intermediatemicroeconomicsshouldberequiredofalleconomicsmajorstobuildasolidfoundation
ineconomictheory.
b.Whenthepriceofagoodgoesup,peoplebuymoreofit.
c.Whenthepriceofagoodgoesdown,peoplebuymoreofit.
d.JeffreyPerloffwasthefirstpresidentoftheUnitedStates.

TrueFalseAmbiguousandExplainWhy
3. Thegovernmentshouldspendmoremoneyonmannedspacemissions.
4. Marketpricesaredeterminedbylargecompanies.
5. Economistsmodelsgenerallypredictthatindividualsallocatetheirscarceresourcessoastomake
themselvesaswelloffaspossible.
6. Extremelywealthypeople,suchasBillGates,dontfacescarcity.

ShortAnswer
7. Mosteconomicmodelsassumethatthegoalofallfirmsistomaximizetheirprofitsallthetime.This
assumption,however,isobviouslynotcorrect,sothetheoriesbasedonthesemodelsarenotvalid.
Howwouldaneconomistrespondtothislineofreasoning?
8. Dr.Mergatroidstheoryisthatthepriceofcompactdisksisdeterminedbytheworkingsofevilspirits.
Whentheevilspiritsareactive,thepriceofacompactdiskrises.Whentheevilspiritsareatrest,the
priceofcompactdisksfalls.Isthisausefultheory?Whyorwhynot?
9.Youmayhaveheardpeopleusethetermthemarriagemarkettodescribetheprocessbywhichmen
andwomenfindmarriagepartners.Inwhatwaysisthemarriagemarketsimilartothemarketfora
servicesuchasahaircutordaycare?Howdoesitdiffer?

10. Howmanyeconomistsdoesittaketoscrewinalightbulb?

Answers to Practice Problems

1. a.Positivestatementsareaboutcauseandeffect.Askingwhetheranincreaseintheminimumwage
willreduceemploymentisatestablehypothesisthatcan,inprinciple,bedemonstratedtobesupported
byempiricalevidence(ornotsupportedbyevidence).
2. b,c,anddarepositivestatementsthisis,testablehypotheses.Choiceaisavaluejudgment,hencea
normativestatement.
3. Ambiguous.Thisisanormative(should)questionwhoseanswerwilldependonthevaluesofthe
personansweringthequestion.Inanswering,youwillbeginbydiscussingthetradeoffsfacing
society.Resourcesarescarce,sospendingmoreonmannedspacemissionsmeansthatlesscanbe
spentonotherthings(includingunmannedspacemissions).Amaximizingindividualwillcomparethe
benefitsfromspendingmoreonmannedspacemissions(e.g.thevalueofadditionalknowledgegained
bythemissions)versusthecosts(e.g.,highertaxes,lostlives).PrincetonUniversityeconomistPaul
KrugmanweighedthesebenefitsandcostsintheNewYorkTimes(February4,2003)followingthe
explosionoftheColumbiaspaceshuttle.Hepointedoutthattheadditionalcostsofputtinghumans
intospacearesubstantial.TheshuttleandInternationalSpaceStationcostabout$7billionperyear.
Thebenefits,heargues,arescant.Machinescancarryoutalmostanyresearchthathumanscandoin
spacescientificobservationandexperimentsorevenminingasteroidsandatamuchlowercost.He
concludedthatNASAshouldnotspendadditionalmoneyonmannedspacemissions.
4. False.Thepricesystemisadecentralizedmechanismbywhichthedecisionsofmillionsofconsumers
andmillionsofproducersarecoordinated.Inlaterchapters,theextenttowhichlargefirmsinfluence
priceswillbeconsidered,butinanycase,thedecisionsofconsumershaveasignificantimpactaswell.
5. False.Thisisthemostwidelyusedassumptionofeconomicmodels.Itisnotaprediction.
6. False.Scarcityisthesituationthatariseswhenpeoplewantmorethantheycangetwiththeirlimited
resources.Wantsgenerallyexceedresources,evenforverywealthypeople.Yourtimeisscarce
becauseyoudliketospendthenexthourstudyingforanexam,catchinguponyoursleep,hangingout
withyourfriends,andplayingthataddictivenewvideogame,butyoucantspendthehourdoingall
fourofthesethingsinthenextsixtyminutes.Becausewealthypeoplealsofacetimeconstraintsand
havelotsofthingstheydliketodo,theyfacescarcity,too.
7. Becausetheworldandtheeconomyaresocomplex,allmodelsmustsimplify.Thus,allmodelsare
subjecttothecriticismthattheirassumptionsdonotreflectreality.Butwecannotthrowoutall
models.Ifwedid,wewouldhavenowayoftestingtheoriesormakingpredictions.Ifwearetoact
sensiblyitiscrucialthatwepredicttheconsequencesofouractionsbeforewemakethem.Instead,we
acceptthefactthatassumptionsdonotperfectlyreflectreality,andfocusontheabilityofamodelto
predict.Ifamodelmakesbetterpredictionsthananyothermodel,thenitwillbeacceptedasvalid
(untilabettermodelcomesalong).Economistsgenerallyusetheassumptionofprofitmaximizing
firmsbecauseithasagreattrackrecordofmakingpredictionsthatmatchtherealworld.
8. MosteconomistswouldrejectDr.Mergatroidstheory.Evenifthetheoryisanaccuratereflectionof
reality,ithasaninsurmountableproblem:Itisnottestable.Unlessthereisamethodofmeasuringthe
activitylevelofevilspirits,thereisnowaytomakepredictionsusingthistheoryandtoshowthatits
predictionsaregenerallycorrect.Inaddition,economistshavedevelopedanalternativetheorythe
theoryofsupplyanddemand.Iftherewereawaytomeasuretheactivityofevilspirits,thenwewould
needtoseeifitmadebetterpredictionsthanthetheoryofsupplyanddemand.
9. Amarketisanexchangemechanismthatallowsbuyerstotradewithsellers.Thereareallsortsof
places(colleges,bars,churchsocials)andinstitutions(networksoffriends,classifiedads,dating
services)thatallowmenandwomentogettogether.Inthissense,thereisamarriagemarket.Menand

womenshoparound(asSmokeyRobinsonputitinhisclassicMotownsong)tryingtofindthebest
bargaininaspouseexhibitingmaximizingbehavior.Themarriagemarketisdifferentfromthe
marketforanotherservicebecauseitislessclearwhoisbuyingandwhoisselling.Bothpartiesseem
tobebuyingandselling.Inaddition,thereisnotusuallyanexplicitpriceinthemarriagemarket.
However,therearecontemporarysocietiesandhistoricalcasesinwhichpricescanbeseenmore
clearlyforexample,whenoneofthefamiliespaystheotheradowry.

10. Howmanyeconomistsdoesittaketoscrewinalightbulb?

Economistsanswerstothisjokecanbeveryilluminating.
a.None.Ifthelightbulbneededtobescrewedin,themarketwouldhavealreadydoneit.(Inother
words,economistshavealotoffaithinthemarketsabilitytogetthingsdone.)
b.Itdependsonthewagerate.(Inotherwords,economiststhinkthatpriceswhichincludewages
areneededinjustaboutanyexplanationinvolvingpeople.)
c.Seven,plusorminusten(i.e.,sometimeseconomicmodelspredictionsareoverlyimprecise).
d.Eight,onetoscrewitinandtheotherstoholdeverythingelseconstant.
ThesejokeswereliftedfromTheWhartonJournal,February21,1994bySelenaMaranijan,whoalso
includesthiszinger:
Q:WhydidGodcreateeconomists?
A:Inordertomakeweatherforecasterslookgood.(Ouch!)